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Paying for Market Quality

Amber Anand (), Carsten Tanggaard () and Daniel G. Weaver ()
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Amber Anand: School of Management, Postal: Syracuse University, 900 S Crouse Avenue, Syracuse, NY 13244
Carsten Tanggaard: Department of Business Studies, Aarhus School of Business, Postal: The Aarhus School of Business, Fuglesangs Allé 4, 8210 Aarhus V, Denmark,
Daniel G. Weaver: Department of Finance, Postal: Rutgers Business School, Rutgers University, 94 Rockafeller Road, Piscataway, NJ 08854-8054

No F-2006-06, Finance Research Group Working Papers from University of Aarhus, Aarhus School of Business, Department of Business Studies

Abstract: One way to improve the liquidity of small stocks is to subsidize the providers of liquidity. These

subsidies take many forms such as informational advantages, priority in trading with incoming order flow, and fee rebates for limit order traders. In this study, we examine another type of subsidy – directly paying liquidity providers to provide contractual improvement in liquidity. Our specific focus here is the 2002 decision by the Stockholm Stock Exchange to allow listed firms to negotiate with liquidity providers to set maximum spread widths and minimum depths. We find, for a sample of stocks that entered into such an arrangement, a significant improvement in market quality with a decline in quoted spreads and an increase in quoted depth throughout the limit order book. We also find evidence that suggests that there are improvements beyond those contracted for. In addition, both inter and intraday volatility decline following the entry of committed liquidity providers for these stocks.

Traders benefit by the reduced costs as well as by the ease of finding liquidity as seen in the

increased trade sizes. We also find that a firm’s stock price subsequent to entering into the agreement rises in direct proportion to the improvement in market quality Thus, we find overwhelming evidence of liquidity benefits to listed firms of entering into such contracts which suggests that firms should consider these market quality improvement opportunities as they do other capital budgeting decisions and that there are residual benefits beyond those contracted for.

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Pages: 43 pages
Date: 2005-11-16
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